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Beyond derivatives: what's driving today's business risks?

Identifying unanticipated risk is like searching for things that go bump in the night - by the time you stumble upon them, it's too late. CEOs gather to discuss the best ways to manage risk.

The nature and consequence of business risk that organizations face are becoming increasingly complex. The rapidity of change, the intensity of competition, and the impact of technological change tend to overwhelm organizations, often leaving CEOs unprepared. In the face of these and other risks, once-secure market positions can be jeopardized. Recent disclosure of possible price fixing at Archer Daniels Midland - not to mention the president-elect's serving as an FBI mole - may seem a bit out of the ordinary, but consider Bankers Trust's $80 million options-trading loss, Intel's slow reaction to its Pentium processor performance controversy, Prudential Life's deceptive sales practices, and Royal Dutch/Shell's turnabout with Greenpeace over the junking of its Brent Spar oil rig.

No organization is immune. Bad things can happen to good companies - and do. So the key for CEOs, and the premise of the following roundtable held in partnership with Arthur Andersen, is how can companies anticipate more, and react less, to real and hidden risks? Can one establish a useful framework to anticipate risk?.

One of the ironies of risk management is its link, in the public's mind, with a financial tool designed to reduce risk, the derivative. The $1.7 billion lost by Orange County, CA, for example, is a sum greater than the GDP of Mozambique and roughly the market value of Bethlehem Steel. Neither is the public reassured when it sees news broadcasts of Wall Street savants such as Felix Rohatyn warning darkly that "26-year-olds with computers are creating financial hydrogen bombs." Not all uncontrollable risk is financial, but the CEO faces an immediate buzz saw when markets move rapidly and exposure to variables of risk mushrooms unexpectedly. The risks abruptly encountered by P&G, Gibson, Bankers Trust, Orange County, and Barings Bank were associated with derivatives, but any investment or asset strategy, from sophisticated interest-rate or currency swaps to fiduciary decisions affecting corporate or pension savings, or even executive incentive plans that involve insurance products, could as readily create vulnerability to shareholder lawsuits and board discomfort.

In its study of how senior executives view risk, Arthur Andersen found that fewer than half of top executives feel highly confident that their companies are effectively managing potential risks. Almost 60 percent expect to revise substantially their control systems.

Roundtable participants agree that a common language and a more integrated approach for assessing risk is needed. As CS First Boston's Allen Wheat says, "CEOs must start by asking the questions never asked." Part of this process includes consistent communication throughout one's company. If everyone understands the goals and objectives - what's acceptable and what's not - a company can to some degree regulate the risk. Awareness, say participants, is critical. If what gets measured gets done, then CEOs must review risk-assessment systems throughout their organizations. In the end, we live in a more volatile, risky world. Risk can never be eliminated, but it's up to the CEO to see that it's managed.

BEST PRACTICES

James G. Hooton (Arthur Andersen): I first started thinking about corporate risk in the context of the oil, cattle, and agricultural industries, which in many respects are the genesis of the derivatives business.

My friends in Houston's oil business often remind me that science consistently provides them with new tools and techniques to help them control risk. For example, scientists discovered better ways to increase the probability of finding hydrocarbons when they drill. But in my industry - finance - no new tools have been created since our school days. Our only options were offloading the equity risk or insuring the risk.

In the meantime, Houston became a boom town in the 1980s, and all my friends, including those in finance, agriculture, and insurance, got rich. Houston added 100,000 jobs in 12 months - and lost them in the next 12 when the bottom dropped out of the oil market. Many of my rich friends suddenly weren't rich anymore, because they found out that the fortunes of their businesses were tied to those of the oil industry. They simply didn't anticipate the risk inherent in a volatile industry, nor did they realize how risk would affect them.

A decade later, corporate America was swept into the "derivatives chaos," burned by misunderstanding and misuse of - ironically - what were supposed to be risk-management tools.

Over the years, I've thought about how both the Houston depression and the derivatives crisis could have been anticipated. What could have been done to better-position Houston for the depression of the mid-'80s? What could have been done to head off the recent derivatives crisis? I don't have the answer, but I do know that if you can't measure risk, you can't control it. And if you can't control it, you can't manage it. That means you are just gambling and hoping to be lucky.

In a recent study we conducted, we discovered that executives now are looking at business risk as an integrated company problem, not an isolated problem of treasury risk or insurance risk. That's a good sign. But while business has identified the problem and begun thinking about it, no one has reached any workable solutions. I suggest we begin by examining and emulating best practices.

Michael I. Roth (Mutual Life Insurance Co. of New York): We've embraced the concept of best practices. But sometimes, those just don't cover unanticipated situations. In the insurance industry, for example, no one realized their sales practices literally could destroy them. How do you manage risk when you're dealing with a $20,000 premium, and the company is socked with a $25 million judgment for misrepresentation? Unfortunately, it seems most of the industry prefers to deal with the problem in court instead of in an operational setting.

Allen D. Wheat (CS First Boston): Companies hire a staff of lawyers to avoid getting sued. In this country, the tendency to sue is just extraordinary, and it wipes out many good businesses.

Samuel J. LeFrak (The Lefrak Organization): You have to stand up all these ambitious lawyers who are costing you a fortune. Yesterday, it was asbestos and lead. Today, it's magnetic fields. Tomorrow, it will be something else.

Robert E. Stauth (Fleming Cos.): To avoid the legal morass, we now try to stipulate binding, third-party arbitration in all our contracts - particularly those concerning our loans to independent retail supermarket operators. We want the deal settled for a few hundred dollars, not a few hundred million dollars in court.

Roth: For the insurance industry, I think the solution lies not in drawing up a piece of paper, but in fostering ethical and cultural environments that don't tolerate problematic sales practices. Deceptive sales practices stem from the drive to earn money by making a sale. Today, compensation packages and performance evaluations place merit on bottom-line performance: making money. Instead of looking solely at whether managers make money, we should ask what type of sales environment they are creating.

Richard L. Measelle (Arthur Andersen): Part of the problem is that there is no accountability. We've empowered employees and given them more freedom, but everyone has lost track of who's responsible for what.

Stauth: That's true. Before everyone started reorganizing, employees knew their responsibilities. Now, they work in cross-functional teams, where no one knows who's on the line when something fails. When we win, we share in the rewards, but when we fail, it's difficult to pinpoint where the guilt lies.

PREDICTING THE FUTURE

Klaus G. Dorfi (Atlantic Mutual Cos.): One of the biggest risks we face in the property and casualty insurance industry is fraud. About 10 percent of our $200 billion in claim dollars go to pay fraudulent claims. Likewise, in the banking industry, estimated annual check fraud is $10 billion. Fraud is a common problem in many industries. In property and casualty insurance, arson is the most common fraud, followed by inflated property damages, staged accidents, inflated injuries, and unethical practitioners.

It is estimated that 25 percent of all workers' compensation claims are fraudulent. What can companies do about that? They must forge a reputation for zero tolerance for fraud. They can do that by establishing a hotline for employees to call in workers' comp fraud; creating special investigative units or hiring law-enforcement officers to review claims files; training employees to detect fraud; using computer technology to uncover patterns of abuse; and taking statements from people under oath.

Stauth: About 25 percent of the workers' compensation claims in the food-distribution business likewise are false. The ingenious reasons people come up with to avoid working are incredible. To deal with this, we set up wellness centers staffed with trained technicians. We assume the claims are legitimate, but we also insist that employees come to work for six hours a day, where we show them videotapes on safety techniques and do some physical therapy. It isn't long before the employee says, "I think I'm feeling better, and if I have to come in every day, I'd just as soon do my job." [Laughter.]

Dorfi: We also favor aggressive return-to-work programs in workers' compensation cases. We want to know about the injury immediately via an 800 number, and we want that person to get superior treatment quickly. Then we assign a utilization person to the case to monitor the patient's progress, and we try to get the employee working part time right away.

We also encourage CEOs to send get-well cards to ensure the person knows someone is concerned and wants him or her back at work.

J.P. Donlon (CE): Wally, what kind of risks do you face in the aerospace industry?

Wallace Barnes (Rohr): The classic currency problem has been largely alleviated in the aerospace business now that the dollar has become the international currency. Of course, now we face another problem in the form of co-production agreements. For example, China buys our airliners but asks for a piece of the manufacturing action. Those reciprocal arrangements that were devised for political and job-creation reasons have spread the risk, because those players come into the game not just as suppliers of a product at whatever the current price may be, but as risk-sharing partners.

Wheat: In terms of things being priced in dollars, that's fine for the revenue side, but everything changes if your costs are in yen or Thai bahts or some other currency.

Barnes: That's true. You really can't escape the problem.

WARNING SIGNS AHEAD

Donlon: Has anyone come up with anything that helps to deal with unanticipated risk?

Roth: For insurance purposes, it's kind of hard to fake death, so we don't have to worry about that. But in terms of preexisting conditions, carriers probably will begin to use genetic testing before writing policies on individuals.

Measelle: We spend a lot of time trying to figure out where the next disaster is going to crop up. In the process, we have created a model that we apply to business risks in three areas - environmental, process, and information for decision making - that affect the company as a whole or some specific process. This model guides several ways. It helps by identifying the consequences of risk, by describing what happens to the organization if risk is realized; it gives examples of how to measure risk; it traces the root causes of risk, examining why risk may exist within an organization; and it creates best practices for reducing risk to an acceptable level.

In addition, our model offers a checklist of warning signs of ineffective business-risk management. For example, you should be warned when there is no linkage of risk to value; when there is no organizational effort to anticipate; when there is ineffective strategic control; when there is no clear, business-risk policy; when risk is not a company priority or when there is a fragmented effort at risk-management; or when there are poor communications.

Ronald G. Anderson (General Re Financial Products): We took a slightly different approach to risk management. In March, we appointed an enterprise risk manager to worry about the unanticipated - such as items we never priced for in our contracts, including pollution liability, asbestos, latent injury - all the things that could wipe you out if you had inadequate capital levels.

Now that we have expanded globally, we've become more decentralized. Thus, we now have to worry about the accumulation of risk across different units within the organization. For instance, an enterprise in London could take a long bet on interest rates in conjunction with our enterprise here in Stamford, which would mean we were unknowingly doubling our bets.

We're also trying to identify potential risks that would affect different units. For example, a major earthquake in Tokyo not only would have insured-loss ramifications, but also might affect currency markets and Japanese banks if real estate were the credit behind certain loans.

Hooton: I now know of 11 companies that have a chief risk officer. Not surprising, they're all organizations in the financial-markets business. Hopefully, once it has become thought of as a best practice, it will spread to other businesses.

Wheat: We have a risk officer. He keeps tabs on the overall market credit and whatever risk we have. He's a very intelligent guy - and luckily he doesn't care about having friends. [Laughter.] This guy sees bad in everything. But that's his job. He challenges any new business activity, checks over the various models, and reports directly to the president.

LeFrak: Companies certainly should have a safety risk officer, a policeman, but in the end, it's the chief executive who has to lay down the law.

Barnes: Does it help for the board to monitor non financial risk, perhaps through the audit committee?

Measelle: Financial institutions often create committees to track particular risks. For instance, some companies have risk committees to monitor potential asbestos problems. Ten years from now, we probably will see many more boards with committees devoted to business risk.

Barnes: Committees other than the audit committee, you mean.

Measelle: It depends. The board should address the subject in one form or another. If the risks are really difficult to deal with - as they are in today's world-class financial institutions - and the audit committee is overloaded, it may make sense to separate them.

Wheat: We would prefer them to be separate. In our audit committee, we would check things such as stress-testing the system. A market-risk committee would then examine the results and decide whether they are acceptable.

J. Carter Beese (Alex. Brown International/former SEC commissioner): The duties of the audit committee are ever-expanding. It's now becoming more than a part-time job. I'm on a committee in which we talk about derivatives policy and good guidelines for the audit committee. Even more important though, we talk with the derivatives people each quarter to find out what the company is trying to protect against and whether the derivative instrument was successful. For example, when we hear that the company made $10 million on its hedge portfolio last month, it raises a red flag, because many derivatives are losses.

Wheat: It's imperative that the audit committee keep tabs on who systematically examines risks, how they do it, and what the best practices are. You don't need a rocket scientist to do this. It's not nearly as difficult as people believe.

DEBUNKING DERIVATIVES

Donlon: How about on the financial side - derivatives in particular? In the wake of the recent derivative debacles, many companies are admitting defeat and shunning these products entirely.

Wheat: First, we must remember that derivatives are a financial tool that lets you precisely calibrate both the risk you are taking and the reward it will bring. When anybody has used it to hedge a particular liability, there hasn't been a problem. The trouble starts when leverage is involved, when people take too great a risk because they don't understand the derivative instrument.

Granted, sometimes that is a result of misrepresentation, but in most instances, executives don't do enough due diligence. Much of the time, it's just plain greed: Somebody tells you you'll make $20 million if certain things happen, so you jump right in. You may be as sophisticated as the dealer, but when the derivative goes sour, suddenly you claim to be a poor ingenue who was led astray.

Despite all the problems, I don't think companies can afford not to use derivatives. CEOs simply must be more knowledgeable. People often say they can't follow all this complicated derivatives stuff. I don't think it's that difficult, especially if you abide by some simple guidelines.

First, identify what you're trying to accomplish. Are you trying to hedge risk or make $30 million? There's a big difference between the two.

Next, look at what might happen in various extremes. If someone says they see sterling trading within $1.54 and $1.56, you have to ask what happens if it trades at $1.52 or $1.57. If the outcome is too risky, don't take the bet.

In terms of pricing, don't be afraid to comparison shop. Always check with at least two banks, unless it is a proprietary idea you're comfortable with. The two banks you check with undoubtedly will kill each other trying to get the deal, which is good for you.

You also should know how to get out of the derivative if it doesn't work. Many times, derivatives are highly structured with no liquidity - and the only guy who can get you out of it is the one who sold it to you in the first place. [Laughter.] Also, beware of restructuring derivatives. A major loss can be hidden by restructuring, but this often means assuming a much bigger risk.

No matter what, never forget you are involved in derivatives. Derivatives are living things; their value changes every day. You must know exactly what the derivative is doing in relation to your original goal. You must track it, just as you would watch a stock price.

Anderson: Until recently, end users haven't had many systems to properly value and monitor derivatives. That's changing now, as more commercial systems are being developed.

Beese: We also need tools to cope with the regulatory burden of today's economy. The growth of regulatory risk can be measured by the pages in the Federal Register. In 1970, the Federal Register had 20,000 pages; last year it had 68,000 pages. And it's not just a quantitative burden: Government constantly changes regulatory rules in the middle of the game.

Let me use derivatives as an example. Often, companies will engage in transactions to reduce risk on their portfolio. But the net capital rules are so antiquated that they have to put up twice the capital, because each trade is looked at on an isolated basis, not on an overall portfolio basis where it's all netted out.

In addition, the SEC has two ways of doing business: enforcing cases based on its own case law or issuing guidelines on what is happening in the marketplace. For the last four years, we knew at the SEC that more than three-quarters of all Fortune 500 companies used derivatives. But we made no pronouncement until there was a disaster. Then we did a specific enforcement case against a specific company, and everyone else had to hire securities lawyers and pay hundreds of thousands of dollars to find out what that case meant for them. The SEC could have achieved the same thing at much less cost by issuing an interpretive release.

Arnold B. Pollard (CE): Now that the derivatives scandals are beginning to recede from memory, are CEOs returning to test the waters, or are they reluctant to get involved again?

Wheat: Many CEOs have been a little slow to get back in, but I think they're starting to come around again. Companies are learning how to better manage derivatives risk, and CEOs are abandoning their old stance of, "I don't understand this formula, so I don't want to do it." Instead, they are starting to realize derivatives are just like any other project they are asked to consider. Even though not all CEOs are engineers, for example, they are capable of analyzing and making decisions about an engineering project. That holds true for derivatives, too.

Donlon: What is likely to be next year's so-called "derivative," particularly as more and more businesses get involved in international transactions?

Beese: The one that is beginning to emerge now is cyber-crime. Now that corporate America is going online, it's exposed to all sorts of computer viruses and unauthorized users who gain access to proprietary information. This is an area crying out for a chief risk officer.

Sebastian E. Cassetta (Smartphone Communications): That's true. Banks and insurance companies, in particular, are moving to make information available online to their clients and employees on the road. Unfortunately, almost anybody can access this proprietary information online, because the fire walls that have been built simply are not strong enough.

Wheat: Companies must make sure someone tracks all the added risk globalization brings them - everything from political risk to currency risk to liquidity risk. To that end, I think the insurance industry will begin to create new and more efficient tools for dealing with risk, especially nonfinancial risk.

Donlon: Jim, did your study look at whether North American companies are better or worse than their international counterparts in identifying and managing risk?

Hooton: While the case studies don't indicate any major difference, my analysis leads me to believe North American companies are ahead of others in addressing risk. First, we openly talk about risk here, conversations that don't happen often in other countries. Also, we tend to bring both the business operations people and derivatives people into the equation.

FULL DISCLOSURE

Beese: Many European companies have used their credit operations as a profit center. Even though that's usually where trouble starts, as a regulator, I have no problem with doing this. I only have one issue: disclosure. If you're going to use derivatives as a profit center, make sure your shareholders know they're exposed to derivatives risk. Then they can make their own decisions. You can't let them wake up and read in the paper that their company suffered a major loss because of derivatives they didn't know about when they invested.

Roth: If you invest in a widget company, you don't expect to take on the added responsibility of derivative exposure, even if there is disclosure.

Beese: But if the company sells in 50 countries, and it doesn't hedge at all, it's taking the same risk.

Roth: I'm not quarreling with the hedging; I view it as pure bottom line.

Beese: As long as you have full disclosure, you can invest in mutual funds that are aggressive and derivatives-based - and you should be able invest in them. You may not want to, but they should be available.

MANAGEMENT STRATEGIES

Donlon: How will you better anticipate and manage your business risk in the future?

Wheat: Managing risk is a continual education process. We have to understand what is going on, identify potential problems, and constantly be on the lookout for change.

Anderson: I think there are many early warning signs to risk, even to what most consider unanticipated loss events. For example, in the property and casualty industry, the first lawsuits began more than 20 years ago, but the publicity didn't really hit until the last five or 10 years. There was ample opportunity for alert companies to change their policies to limit exposure.

In the life-insurance industry, companies could have anticipated some of the sales-practice problems that have cropped up recently. And anecdotal evidence prior to 1994 suggested that improper derivatives instruments were being sold to some widow and orphan multinationals. They should have known better, but they didn't.

Barnes: Aside from outright dishonesty or malfeasance, I think the biggest enemy is lack of awareness. So I favor creating a checklist of risks that the board goes over for an hour or two at least once a year.

Beese: It's the board's job to set and enforce the policy procedures that management lives with on a daily basis. When it comes to derivatives, the board must ensure that the right third-party, independent auditor is in place.

Pollard: Life is, in part, a risky trip. There are no guaranteed outcomes. And so, I think worrying about the unanticipated risks is a red herring. Nevertheless, I've learned that there is a greater sensitivity to the heightened range of risks that enterprises face in our more sophisticated global world. Management now has checklists, risk officers, and definitions of all kind of risks, from financial to Cyberspace. Everybody's warned. The smart companies will take appropriate managerial action and some board action.

Stauth: I like the idea of having a written business plan that deals with risk management. My company doesn't have such an animal, but we will after today. I advocate a written policy developed by the senior management team that can be filtered through the organization, so the managers making the daily operating decisions know whether they are adhering to the company's risk profile. However, the only way this works is if it's a living document that is reviewed quarterly, not stuck in a drawer.

Measelle: The ability to anticipate risk has become not only important, but an issue of survival. There is a lot more to this area than simply derivatives or environmental risk. Just doing business today poses incredible risks. We need to shift from a reactive to a proactive outlook.

There's an old saying that the more things change, the more they remain the same. Perhaps they're just lucky, but the companies in which management sets the right tone somehow seem to avoid many risk problems. And conversely, those companies in which management seems intent on next quarter's earnings seem to fall victim to risk.

As we move into Cyberspace, people tend to think a new world of risk lurks out there, but I think the basic integrity risk is what keeps most CEOs up at night. Ultimately, they are responsible for letting employees know what behavior won't be tolerated.

Roth: We must foster an environment in which people who are taking risk ask themselves, "Would I put my money where I'm asking the company to put its money? Would I advise my family to invest in the financial product I'm selling?" Creating this type of corporate atmosphere will benefit you in the long run. Unfortunately, big business has a ways to go before it reaches that level. Nevertheless, it is a goal we should strive for.

Donlon: Is it getting better or worse?

Roth: In the area of consumers it has to get better, because customers increasingly won't deal with companies that have bad sales-practice reputations.

Stauth: They don't have to. Competition ensures that customers have plenty of choices, and they certainly don't want to take on the risk of dealing with a company that has an unsavory reputation.

Cassetta: Risk is everywhere. In the end, it all comes down to basic management principles. As good managers, we have to get the best information possible, make our decisions, and go with them.

RELATED ARTICLE: A Who's Who Of Roundtable Participants

Ronald G, Anderson is chairman of General Re Financial Products, a Stamford, CT-based financial-products and services unit of General Re Insurance.

Wallace Barnes is chairman of $918 million Rohr, a Chula Vista, CA-based manufacturer of components for the commercial and military aerospace industries.

J. Carter Beese is vice chairman of Alex. Brown International, a subsidiary of Alex. Brown, Inc., a Baltimore, MD-based investment banking firm with assets of $1.28 billion. He is also currently a senior adviser at the Center for Strategic and International Studies, and a former SEC commissioner.

Sebastian E. "Sam" Cassetta is chairman and chief executive of Stamford, CT-based Smartphone Communications, a provider of online information and services.

Klaus O. Dorfi is president and chief operating officer of the Atlantic Mutual Cos., a New York-based property and casualty insurance provider with premiums of $700 million.

James G. Hooton is managing partner, Audit & Business Advisory, at Arthur Andersen, a $3.5 billion audit, tax, and business advisory services firm.

Samuel J. LeFrak is chairman of The Lefrak Organization, a privately held real-estate development, oil, gas, entertainment, and communications company based in Forest Hills, NY.

Richard L. Measelle is managing partner, Arthur Andersen.

Michael I. Roth is chairman and chief executive of Mutual Life Insurance Co. of New York, an insurance company with $14.2 billion in assets and $2 billion in revenues.

Robert E. Stauth is chairman and chief executive of Oklahoma City-based Fleming Cos., a $15.7 billion wholesale food distributor and retail-services company.

Allen D. Wheat is president and chief operating officer of CS First Boston in New York, an investment banking firm with long-term capitalization of $5.5 billion.

RELATED ARTICLE: Derivatives: Put Them To The Stress Test

Spectacular corporate losses from bad derivatives trades have sullied the "D-word." No one wants to be the next Procter & Gamble, which lost $157 million before taxes from interest-rate plays that went sour when rates soared in 1994. And on the sell side, no one wants to become another Bankers Trust, which brokered the P&G deal and, as a result, is locked in a bitter lawsuit with the giant consumer products company.

Yet companies that shun these risk-management tools - or don't use them responsibly - expose themselves to potentially damaging swings in currencies, interest rates, commodities, and tradeable securities. Theoretically, shareholders could even sue a company over a loss, claiming it was remiss in not hedging business risk with derivatives. Banc One's CEO, John B. McCoy, for one, is a believer in these financial instruments - so much so that he went on road shows to reassure investors about Ohio-based Banc One's derivatives use. Vulnerable to interest rates, the bank uses swaps to hedge its exposure.

Some derivatives, however, are riskier than others. Can one predict their performance under many circumstances?

The answer is a conditional yes.

"We take the transaction and develop a table to show where the sensitivities are to exposure," says Gifford Fong, president of Walnut Creek, CA-based Gifford Fong Associates, which does independent valuations and stress-testing of derivatives. "We look to see what, for example, a 100 basis points change in the interest rate would mean in the price change in the derivative itself. We look at which derivatives are sensitive to interest rates, volatilities, and currencies."

A straight option on the future direction of U.S. interest rates is a common portfolio hedge. So is a plain-vanilla interest-rate or currency swap. These are far less risky than, say, an interest-rate contract whose return depends on the inverse of the change in the London Interbank Offered Rate. If this arrangement, known as an "inverse floater," sounds complicated, that's because it is. Derivatives have become so elaborate that a buyer can actually take an option on something that doesn't exist. A "30-10 swaption" is a 10-year option on a 30-year U.S. Treasury bond. It's an interest-rate bet that gives the right to buy a bond that hasn't yet been issued.

In general, the more a derivative is laden with customized intangibles and the more back-flips and twists it does for a payoff, the greater the chance for tremendous reward - or punishment. "Anything used inappropriately can get you into trouble," warns Paul Isaac, a former chief economist at New York-based Mabon Securities.

Derivatives run aground when management doesn't understand what it's buying, or when the derivatives used are incompatible with a company's investment policies and objectives. Incredible but true: Despite the prospect of massive losses, more than a few companies fail to do their derivatives "due diligence."

But if derivatives are becoming more sophisticated, so are the tools that measure them. Computer models can stress-test a derivative to determine its impact on a portfolio. A computer runs assumptions on a valued derivative to see how it will fare under a variety of circumstances.

At Banc One, every instrument is stress-tested, says Steven Bluhm, a senior vice president at Banc One Funds Management Co., which handles the bank's interest-rate risk. "We try to manage moving averages," he explains. "We identify what would happen to forecasted earnings under different interest-rate scenarios." Senior corporate officials, including President Richard Lehmann, meet every other week to plot strategy. McCoy attends the monthly policy committee meeting.

"Unless you do the stress-testing, you don't fully understand the risk characteristics of that derivative," says Fong. And having peered into this crystal ball, management would be hard-pressed to pin a sudden reversal of fortune on a broker, any more than it could blame Alan Greenspan.

Jonathan Burton

RELATED ARTICLE: Be Prepared

A tiny flaw in a computer chip sends Intel reeling. Poisoned Tylenol pills threaten Johnson & Johnson's credibility. Chevron finds trouble on a major oil project in a remote region of the former Soviet Union Gas company Enron Corp. sees an Indian state government scrap its multibillion dollar power-plant contract.

Today's corporations are forced to grapple with an increasing array of risk. Most companies have a solid disaster recovery plan in place, which may include purchasing specialized insurance or, as Wall Street's high-flying brokerages have done, duplicating hard-wired trading facilities.

But there's no replacement for directness and honesty, with employees or with the public. And it must come from the top-down. A CEC sets the moral tone for a company in crisis and how the public views it.

"The most successful companies are those that respond promptly to the public, and are respectful of social and environmental conditions and the world in which they do business," says Mark Grody, executive vice president of communications consulting firm Ogilvy Adams & Rinehart in Los Angeles.

Intel CEO Andrew Grove publicly down-played a flaw in his company's Pentium chip last November and faced a firestorm of consumer complaints. A month later, Intel agreed to replace any Pentium chip for free. The company took a $475 million charge against 1994 earnings, but appeased most of its customers.

Talking plain, taking responsibility, and acting immediately have saved many corporate reputations. When seven people died from cyanide-laced Tylenol capsules in 1982, Johnson & Johnson recalled the product and instituted safe-packaging. In 1990, Perrier found its bottled water contaminated with benzene and withdrew it from the marketplace for three months until it could correct the problem - and the perception.

Likewise, a lack of communication and responsiveness have derailed many corporate images. Who can forget Three-Mile Island and the Exxon Valdez?

International terrorism has introduced yet another wrinkle to risk. The World Trade Center bombing in February 1993 forced companies to scramble for alternate facilities. On the 85th floor of Two World Trade Center, the boutique investment banking firm of Keefe, Bruyette & Woods had no formal contingency plan, but it did save its electronic data. Within three days of the blast, traders were set up in rented offices across the Hudson River in New Jersey.

Most large Wall Street brokerage houses such as Merrill Lynch have similar alternate sites for traders and other employees. Waiting for a disaster that no one wants to happen, these big rooms are equipped with telephones, modems, and computer terminals.

Multinational companies have yet another worry - dealing with the vagaries of elected officials. The new fundamentalist government of the Indian state of Maharashtra decided last August to pull the plug on Houston-based Enron Corp.'s $2.8 billion power-plant project. And Chevron, concerned about rising Kazakh nationalism and haggles over pipeline routes, cut spending on a prized $20 billion oil exploration project in the former Soviet republic of Kazakhstan in 1994.

U.S. mining, oil, and gas companies overseas are particularly vulnerable to local perceptions that they are robbing the national patrimony, explains Edward Grubb, managing director for the North American operations of London-based Control Risks Group. Some protection can be found from multilateral lenders including the World Bank, the U.S. Export-Import Bank, and the Overseas Private Investment Corp., which provide risk insurance and loan guarantees. Small-business owners need to tailor their insurance to possible financial crises. Standard policies provide insurance against business interruption, or lost income, plus property and liability coverage.

Before doing business in another country, a company should scrutinize the political, judicial, and economic systems involved. Grubb's checklist includes identifying the important figures, their policies and opposition; how other companies have fared; and how the courts view foreign entities. "Planning doesn't prevent you from having problems," he says. "It merely helps you deal with them successfully."

Jonathan Burton
COPYRIGHT 1995 Chief Executive Publishing
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Author:Burton, Jonathan
Publication:Chief Executive (U.S.)
Article Type:Panel Discussion
Date:Oct 1, 1995
Words:6097
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